Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Qian Jiang Water Resources Development Co.,Ltd (SHSE:600283) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Qian Jiang Water Resources DevelopmentLtd

How Much Debt Does Qian Jiang Water Resources DevelopmentLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2022 Qian Jiang Water Resources DevelopmentLtd had CN¥1.57b of debt, an increase on CN¥1.43b, over one year. However, it does have CN¥817.2m in cash offsetting this, leading to net debt of about CN¥751.8m.

How Healthy Is Qian Jiang Water Resources DevelopmentLtd's Balance Sheet?

According to the last reported balance sheet, Qian Jiang Water Resources DevelopmentLtd had liabilities of CN¥2.08b due within 12 months, and liabilities of CN¥1.83b due beyond 12 months. On the other hand, it had cash of CN¥817.2m and CN¥179.1m worth of receivables due within a year. So it has liabilities totalling CN¥2.92b more than its cash and near-term receivables, combined.

Qian Jiang Water Resources DevelopmentLtd has a market capitalization of CN¥5.08b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Qian Jiang Water Resources DevelopmentLtd's net debt of 1.6 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 8.6 times interest expense) certainly does not do anything to dispel this impression. And we also note warmly that Qian Jiang Water Resources DevelopmentLtd grew its EBIT by 13% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is Qian Jiang Water Resources DevelopmentLtd's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Qian Jiang Water Resources DevelopmentLtd recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Qian Jiang Water Resources DevelopmentLtd's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to to cover its interest expense with its EBIT isn't too shabby at all. We should also note that Water Utilities industry companies like Qian Jiang Water Resources DevelopmentLtd commonly do use debt without problems. Looking at all the angles mentioned above, it does seem to us that Qian Jiang Water Resources DevelopmentLtd is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Qian Jiang Water Resources DevelopmentLtd that you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.